What would a GME or AMC quick squeeze imply for a Luxembourg investor? – VAT

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Since the end of January 2021, the price campaign on shares of the video game retailer GameStop Inc (“GME“) and other shortened companies like AMC Entertainment (“AMC“) has caught the attention of the financial world. The story is presented as a group of individual investors betting against short sellers and hedge funds in an attempt to provoke a short squeeze that many believe will mark financial history. Online brokers , US Congressmen This fascinating, evolving chain of events featured financial news and online discussion boards.

But that particular angle of history isn’t the only one to look at. The dramatic rise in GME’s share price from $ 4 to over $ 400 and from $ 3 to $ 19 per share for AMC in just a few weeks has also opened up opportunities for certain investors who hold other stocks in the companies.

For example, it has been reported that Silver Lake, a US buyout company, was able to cash in on a convertible bond issued by AMC at a conversion price of around $ 13, generating a huge and likely unexpectedly short-term profit What some other hedge fund managers and commentators have called the “deal of a lifetime”. However, no specific indication has been given of the potential impact of such trading on income tax and this is now the subject of the discussion below.

What would a similar trade mean for European investors?

While in Europe these types of securities and transactions can be held and executed directly by exempt institutional companies such as mutual funds, many global credit and special situation managers structure such investments using one or more SPVs, which are often used as taxable corporate entities that have a diversified portfolio hold of credit papers.

These SPVs are typically funded with debt, and interest expenses on such debts are generally deductible from the SPV’s taxable base under certain conditions. As a result of the EU-wide implementation of the Tax Avoidance Directive (Directive (EU) 2016/1164 of July 12, 2016 – “A LITTLE BIT“) Has Luxembourg introduced specific rules to limit interest tax deductibility (the”IDLRThe limit applies to so-called “excess borrowing costs” (ie the amount by which the borrowing costs exceed the interest income of a certain year) and corresponds to the higher amount of EUR 3 million or 30% of the tax EBITDA per fiscal year.

In this context, the definition of the cost of debt is of paramount importance. On January 8, 2021, the Luxembourg tax authorities published a new circular No. 168bis / 1 (the “Circular“) to provide information on the interpretation of the IDLR. According to the circular, borrowing costs may only relate to deductible interest expenses, ie non-deductible interest expenses, regardless of the reason for non-deductibility (e.g. anti-hybrid rules). To apply the IDLR, Therefore, it should first be checked whether the relevant costs are deductible under the other provisions of Luxembourg tax law. In a second step, the nature of the costs must be checked in order to determine whether or not they fall within the scope of borrowing costs within the meaning of the IDLR such withholding restrictions apply, the resulting potential tax burden can have a major impact on the Fund’s returns.

While not all bonds or receivables are convertible, the impact of additional equity injected into plain vanilla debt issuers can have a direct impact on the valuation and redemption value of those debt instruments. Under the IDLR in Luxembourg, a deduction for the impairment of (presumably) bad debts does not result in borrowing costs for the creditor. The reverse of such an impairment should therefore also not constitute interest income. This, in turn, means that gains on impaired or discounted debt can only be offset by tax-deductible interest expenses up to a certain limit, creating a potentially increased tax burden for their holders.

The conversion of debt into equity is more complex to analyze. On the one hand, an exchange of assets for Luxembourg tax purposes is usually characterized as a sale of the asset followed by an acquisition of the other asset acquired in the exchange and therefore any difference in value between the two should be a gain (or a loss). According to the circular and the principle of symmetry laid down therein, the characterization of income and profits in the hands of the holder of a security should in principle repeat that at the level of the issuer. Therefore, when redemption premiums for convertible bonds are viewed as a cost of debt to the issuer, the premiums should also be viewed as an “interest rate equivalent” for the lender.

However, income generated after the subsequent sale of the shares or the new equity received in exchange for converting the debt is almost always considered to be interest-free income (i.e., “bad income” as defined by the IDLR). In these situations, it is therefore extremely important to understand and monitor the exact sequence of transactions in order to determine the applicable tax treatment and to determine whether or not any portion of the interest expense is non-deductible for tax purposes.

Asset managers financing discounted or convertible debt securities with with-profits or other credit instruments (e.g. debt securities) may therefore need to review their current structure to identify potential tax risks and, if necessary, take the necessary steps to potentially “do business with” prevent a lifetime “from getting mad when an unexpected tax burden ruins the party.

And … oh yes, for Luxembourg individual investors, short-term capital gains (less than 6 months) and short-selling gains are considered speculative and are therefore subject to individual taxation at the maximum tax rate.

The content of this article is intended to provide general guidance on the subject. You should seek advice from a professional about your particular circumstances.